Time for banks to gang up on rating agencies

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s time for banks to knock ratings agencies off their pedestal. For all their well-documented flaws, credit ratings are still hard-wired into the financial system. An industry-wide downgrade by Moody’s may provide the catalyst to curb the agencies’ power.

In mid-February, Moody’s said it might lower the ratings of 17 large wholesale banks. It has good reason to do so: sovereign turmoil, the burdens of new regulation, and banks’ own lack of transparency are all legitimate concerns. But if Moody’s goes ahead, some lenders may see short-term funding dry up, or have to post additional collateral to derivatives counterparties. With turmoil in the euro zone and JPMorgan’s trading woes already undermining confidence, a downgrade is the last thing that banks need.

Most of the time, ratings agencies lag rather than lead the market. When Moody’s last week lowered ratings on the debt of Spanish banks, investors shrugged – the shift confirmed what they had concluded months earlier. Similarly, many investment banks already pay higher prices for their debt than other companies with similar ratings. That implies a downgrade is already priced in.

Yet while Moody’s opinion is unlikely to tell investors anything they didn’t already know, lower ratings will affect large investment banks in two specific ways. First, it will hurt their derivatives businesses. Many investors will only deal with counterparties with credit ratings above a certain minimum level. A bank whose rating dropped below A3 might lose business, or have to post extra collateral for trades. For example, a three-notch downgrade by Moody’s would require UBS to put up an extra 7 billion Swiss francs of collateral.

Even worse, the downgrade could cut off some sources of funding. As part of its review, Moody’s is considering stripping some banks of their top short-term rating. This will make it difficult to attract investment from U.S. money market funds, many of which are prohibited from buying the commercial paper of companies which do not have the highest short-term ratings from both Moody’s and Standard & Poor’s. Those banks will be forced to seek funding elsewhere.

A short-term downgrade could also spook large companies and other institutions that have stashed surplus cash with the affected banks. Precise figures are hard to come by. But senior executives say that in a worst-case scenario some banks could see tens of billions of dollars head for the exit.

For the banks concerned – the list includes Bank of America, Barclays, Citigroup, Goldman Sachs, Morgan Stanley, Royal Bank of Scotland and UBS – this is uncomfortable rather than life-threatening. They have had several months to prepare for the worst, and most of them have plenty of excess liquidity on tap. In the longer term, they could reduce counterparty concerns by pushing more derivatives contracts through centralised clearing houses.

A sweeping downgrade also makes it more likely that creditors and counterparties will eventually adjust their criteria to accept lower ratings. In this sense, Moody’s downgrade could be like S&P’s decision last year to strip the United States of its triple-A rating: investors now make do with double-A instead.

Nevertheless, the threat of a downgrade could be the wake-up call the industry needs to reduce the impact ratings have on their business. This is long overdue: after the financial crisis destroyed credit ratings’ credibility, regulators and politicians vowed to curb their power, but nothing much has happened. The European Commission has proposed new rules designed to clip the wings of Moody’s and S&P. And Dodd-Frank legislation in the United States requires regulators to remove references to ratings from their own rules. Yet the reality is that many banks and investors still use ratings as a crutch when determining financial strength – and enshrine them in official contracts.

One option is for banks to collectively refuse to enter into derivatives contracts that include a ratings trigger. They could also refuse to accept deposits and other funding from institutions that base their decisions on short-term ratings. This will not be quick or easy: stronger banks will instinctively use better ratings to attract business, while weaker ones have less power to demand change. But joint action is worth a try. It took decades for financial markets to hoist ratings agencies onto their pedestals: Moody’s downgrade could be just the impetus that is required to knock them off it.

If ratings reflect the cedit quality of a bank then why is this a problem ones a ratingagency gives the bank a downgrade?
Like you said Moody’s gives these banks months to prepare, counterparties need something to protect themselves from over risk taking counterparties like the ones you mentioned. The downgrade reflects the increased risk (though a little late) and gives investors some sort of protection. Ratings are therefore a ruler that is widely accepeted. The risk is a problem not the ruler.

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